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How Forex Brokers Make Money


September 20, 2015 Facebook Twitter LinkedIn Google+ Articles of the Day


 

Most Forex brokers aren’t your traditional financial intermediaries found on Wall Street. When operating in international currency and CFD markets, full understanding of the structure and strategic objectives of Forex brokers may mean a difference between success and utter failure for a trader. There is much more to the subject than just transparency of commission structures and hidden costs. Knowing how to spot a truly professional brokerage solution, which will serve your interests instead of stuffing their own pockets with your money, will go a long way in safeguarding your capital.

What is the business model of most Forex brokers? How do they operate and make money? What are the fundamental differences from traditional structures that equity investors are used to?

There are only two business models among the thousands of brokers globally. The first and most commonly used model is known as market-making, or B-Book. Whether regulated or not, such brokerages present the greatest risk of financial losses and missed profits to clients. B-Book is a technical term, which implies that the provider will virtually execute trades without sending them to live markets. Such methodology allows the virtual broker to keep all trades on the books, acting as counterparty to every transaction under assumption that the prevailing majority of clients will eventually lose all money. Client loss here becomes broker gain, and vice versa.

You may have read numerous reports with trader complaints covering a variety of manipulative broker techniques they encountered when trading in Forex and CFD markets, including stop-hunting, forced delays in trade executions, unjustified price spikes, artificial gaps, unexpected slippage and drastic surge in spreads, among the many other shady practices that witnesses report. The chances are, few would know the underlying reasons behind such broker behaviours. In reality, it all comes down to the factors of opportunity and financial incentive. Since their profitability and their very financial survival is driven by client losses, such brokers tend to misuse the technical facilities of B-Book systems, interfering with client trades, manipulating execution and even dressing up price quotes to maximise their own profits.

IMG 01 Illustration of B-Book Model

Let’s have a look at actual numbers. Presented below is a screenshot from a small-sized B-Book broker that went out of business recently, deciding to share this valuable information with investors. Profitability of this broker with only three employees is mind-boggling. Truly so, they make money from thin air:

IMG 02 Screenshot of Broker Profits

As you can see above, clients altogether lost an astonishing $195,000 in one day of trading. B-Book brokers will transform these virtual client trades, where no actual market trading occurred in the first place, in broker’s own profits. The very next day, these funds are being used to pay for even more advertising, selling the concept of easy money to trusting investors. This is precisely why the brokers that have some of the highest online visibility due to heavy advertising, use B-Book models, while professional ECN brokers have relatively small presence online and advertise their offers within reasonable budgets. High competition for advertising spots saw brokers’ marketing costs skyrocket, and it is generally the case that only market-making B-Book brokers, who essentially use client money to pay for advertising, are able to afford the cost.

Scary consequences of B-Book business models
Most common grey techniques used by B-Book brokers are presented in the screenshot that follows. You can clearly see that brokers have the technical means to force execution delays, damaging client accounts when traders may need to exit the market urgently on huge price swings.

IMG 03 Inside The B-Book System

 

Alternative DMA/STP solutions for professional traders
DMA/STP, often referred to as simply ECN brokers, pursue best interests of their clients in contrast to the above practices. Also known as A-Book brokers, DMA/STP firms operate solid brokerage businesses as they are meant to be. Equipped with technical means to deliver absolute best trade execution, DMA/STP brokers are driven by client-centric business models, which motivate them to continuously improve their services, reduce trading costs and provide solutions that help traders achieve better results. DMA/STP brokers will deliver true market prices and route all client trades to international banks and other liquidity providers through ECN environments. Concord Bay is one example of an international brokerage that operates according to a 100% DMA/STP business model, in a fair and transparent business relationship where the broker is motivated to help clients succeed in the markets, growing trading volumes and facilitating client profitability a win-win relationship.

The Bottom Line
If you ever thought of making money with a market-making broker, you might as well forget it altogether as the chances of your dreams materialising are next to none. The only viable brokerage solution for professional Forex and CFD traders is one where broker’s financial motivation is tied to client success, with a commission-based compensation instead of the more common B-Book model where broker makes money on client losses. DMA/STP firms, like Concord Bay, also known as A-Book brokers, cater to professional traders and investors, delivering superior execution and first-rate electronic trading services structured to facilitate success of their clients.

IMG 04 Illustration of A-Book Model

 

About the Writer: Alex Bowman is a long-time veteran of Forex markets, a successful investor and asset manager with over 20 years of experience in equities and alternative investments. For years, he worked for top global banks and managed currency-trading teams for proprietary trading firms and New York hedge funds. He is an expert in risk management strategies, and currently assists multinational corporate clients in managing and hedging their exposure to foreign currencies. In his spare time, Alex shares his experience with the trading community, publishing his research on diverse topics covering investments, financial markets and trader psychology

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